Foreign investments in U.S. real estate, particularly in New York City, have dramatically increased over the past several years and are expected to grow.
The foreign interest in real estate holdings has been driven by various factors, including the U.S. “effectively becoming the biggest tax haven in the world”, the ever rising prices of real estate in New York, the demise of the Swiss banking system, and unstable economic and political situation in home countries.
While foreign investors flock to New York City to acquire real estate, very few realize the dire tax and legal consequences of investing into U.S. real estate without proper advance planning.
Frequently, problems arise after the property is sold, or after the property has passed through the estate, and the owner/beneficiary is left with a hefty tax bill.
For instance, if the foreign client’s investment in NYC real estate is improperly structured, a combined Federal, New York State and New York City tax rate on gains realized from selling the property could be as high as 65%.
On the other hand, proper advance planning and advice may substantially reduce and, in certain cases, completely eliminate U.S. taxation associated with ownership and sale of real estate in the U.S.
Four major considerations must be taken into account when purchasing New York City real estate and devising real estate holding structure: (1) taxation of operating income and gains from sale; (2) repatriation of profits; (3) taxation upon death; and (4) privacy and reporting requirements.
The appropriate real estate holding structure depends heavily on the client’s goals, future plans, country of residence and the underlying reasons for investing in the U.S. real estate.
INDIVIDUAL DIRECT OWNERSHIP OF NEW YORK REAL ESTATE
A foreign investor may own U.S. real estate directly in his or her own individual name. This is the most primitive and cost-effective form of ownership, yet provides the least long-term benefits and exposes the owner to liability, tax reporting requirements, estate taxes, Foreign Investment in Real Property Tax Act (“FIRPTA”) withholding tax, and New York State withholding tax.
Privacy: None. Purchaser’s name will appear in New York City public records.Reporting Requirements: Individual files Federal and New York State income tax report. Federal income tax report is filed on Form 1040. NY State income tax return for nonresident is reported on Form IT-203.Liability: Personal and UnlimitedTaxation of Gains on Sale: Federal long-term capital gain tax up to 20%, if applicable holding period requirement is satisfied; New York State tax of up to 8.82%. Medicare Tax on net investment income at the rate of 3.8% may apply as well.
NY State Withholding. 8.82% on the realized capital gain. Seller must file Form IT-2663 to report estimated income taxes in connection with the sale.Taxation of Rental Income: If taxed under “gross income” regime, automatic 30% withholding on gross rental receipts, plus New York State income tax might apply. If the rental income is taxed under the “net income” regime, it would be taxable at a 39.6% federal rate with respect to ordinary income, plus New York State income taxes of up to 8.82%. Combined effective tax rate would exceed 40%. Amounts subject to withholding are reported on Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding.Repatriation of Funds: No additional tax in the U.S. besides FIRPTA and NY State WithholdingEstate Taxes: Federal Estate Tax up to 40% + New York State estate tax up to 16%. For nonresident aliens, the applicable exemption continues to be limited to only $60,000 – both the Federal and the State Estate tax due when the value of taxable estate exceeds $60,000. Individual direct form of ownership is only chosen by a small percentage of foreign investors. If the property is rented out, the owner will have to file a U.S. income tax return reporting the U.S. income. The owner will also be personally liable for any damages that result from that real estate.
In addition, the investor’s individual name as an owner of real property will appear in New York City public registry for property records (ACRIS).
Upon sale of real property, the foreign investor will be subject to FIRPTA withholding tax at the rate of 15% of the total sale price (not on gain realized from sale) subject to certain exceptions. FIRPTA tax is withheld from the purchase price by the buyer and is treated as an advance payment of U.S. taxes.
The sale transaction would also be subject to New York State withholding tax of 8.82% calculated based on the projected capital gain realized from the property sale.
Foreign seller then must file taxes on the sale of the property for the year in which the sale took place. Since the seller is only responsible to pay applicable tax rate on gains received from the transaction and not the purchase price at which the property was sold, any excess of FIRPTA and New York State withholding tax would be refunded to the seller during the relevant tax period.
If the property was held for at least one year, capital gains will be taxed at the rate of up to 20% plus New York state income taxes of up to 8.82% (Medicare tax of 3.8% of on net investment income might apply). If the property was held for less than a year, no capital gain treatment would be permitted and the sale would be taxed at ordinary Federal and State income tax rates.
Things become more complicated if the property is rented out and, thus, produces income. Generally, such income is treated as passive investment income and the foreign person is subject to a flat 30% tax under “gross income” tax regime, no deductions are permitted.
If the foreign person actively manages the property, the rental income might be treated as income effectively connected to U.S. trade or business and, thus, will be taxed under the “net income” regime at ordinary income tax rates after making permissible deductions. The combined Federal and New York State tax rate on rental net income would exceed 40%.
In certain circumstances, it might be advisable to elect taxation at ordinary income rate to benefit from deductions. The harsh 30% withholding tax may also be mitigated through applicable tax treaties, depending on the residency of the beneficial owner.
Foreign persons are also subject to Federal estate tax on property owned in the U.S. when they die. Thus, if one does choose to own U.S. real estate individually, the foreign individual investor will be subject to an estate tax in the event that investor passes away while owning the U.S. real estate.
Nonresident aliens are subject to U.S. estate and gift taxation with respect to U.S. real property interest at maximum federal rate of 40% plus the applicable state tax rate, which is currently 15-16% in New York. U.S. citizens and resident aliens have an individual exemption from the estate tax up to $5.49 million dollars (for 2017). This means an individual can leave up to $5.49 million to heirs and pay no federal estate or gift taxes. The New York State exemption for 2017 is $5.25 million.
Conversely, nonresident aliens are afforded an estate tax exemption of only $60,000. Thus, the estate tax is due (up to 55% combined tax rate) on the value of all U.S. situs assets, including real estate, the value of which exceeds $60,000.
The New York taxable estate for the estate of an individual who was a nonresident at the time of his or her death will be computed in the same manner as the New York taxable estate for the estate of a resident subject to certain exceptions.
OWNERSHIP OF NEW YORK CITY REAL ESTATE THROUGH DOMESTIC LIMITED LIABILITY COMPANY
Foreign investors may acquire New York City real estate in the name of a limited liability company. By default, limited liability companies are pass-through entities and, thus, the tax consequences would be similar to the ones described in the section above.
However, the big difference is that a limited liability company provides the investor with a limited personal liability for losses related to the real estate investment – individual foreign investor’s personal assets are not exposed to the liabilities of the investment. This is often the best vehicle for a smaller investor in U.S. real estate.
Privacy: Limited. Name of the company’s owner does not appear in public records (ACRIS). Under the new rules issued by the U.S. Department of Treasury, title insurance companies are required to identify and report the true “beneficiary owner” behind a legal entity involved in high-end residential real estate transactions in Manhattan subject to certain exceptions and conditions.Reporting Requirements: f a single-member LLC does not elect to be treated as a corporation, the LLC is a “disregarded entity”, and the LLC’s activities should be reflected on its owner’s federal tax return. If investor is an individual, the activities of the LLC will generally be reflected on Form 1040. NY State income tax return for nonresident is reported on Form IT-203.Liability: LimitedTaxation of Gains on Sale: Federal long-term capital gain tax up to 20%, if applicable holding period requirement is satisfied; New York State tax of up to 8.82%. Medicare Tax on net investment income at the rate of 3.8% may apply as well.FIRPTA Withholding Tax Due on Sale: If the sales price is $1,000,000 or more, the withholding rate is 15% of the gross purchase price. NY State Withholding: 8.82% on the realized capital gain. Seller must file Form IT-2663 to report estimated income taxes in connection with the sale.Taxation of Rental Income: If taxed under “gross income” regime, automatic 30% withholding on gross rental receipts, plus New York State income tax might apply. If the rental income is taxed under the “net income” regime, it would be taxable at a 39.6% federal rate with respect to ordinary income, plus New York State income taxes of up to 8.82%. Combined effective tax rate would exceed 40%.Repatriation of Funds: No additional tax in the U.S. besides FIRPTA and NY State WithholdingEstate Taxes: Federal Estate Tax up to 40% + New York State estate tax up to 16%. For nonresident aliens, the applicable exemption continues to be limited to only $60,000 – both the Federal and the State Estate tax due when the value of taxable estate exceeds $60,000.The limited liability company provides for the best income tax treatment and limited liability for the investor’s assets. It can also provide the foreign investor with additional privacy protections. However, the limited liability form of ownership also does not protect the foreign investor from U.S. Federal and State estates taxes upon death.
OWNERSHIP OF NYC REAL ESTATE THROUGH DOMESTIC CORPORATION
The use of a U.S. corporation by an individual foreign investor is very limited and, in most cases, not advisable.
That is because ownership of a U.S. corporation that owns real estate does not solve any U.S. estate tax problems and shares of stock in a U.S. corporation are also included in the foreign investor’s estate.
This structure also creates an extra tax burden for the foreign investor with increased capital gain rates and a second layer of taxation upon repatriation of profits.
It does provide the investor with the liability shield and eliminates the need for the individual to file annual U.S. tax returns. However, the company must report information about a foreign individual(s) that own directly 20% or more, or own 50% or more of the company’s voting stock.
Privacy: Limited. Name of the company’s owner does not appear in public records (ACRIS).Reporting: In the end of a given tax year, a company files Federal and New York State corporate income tax returns. The Federal income tax return is filed on Form 1120. The company must report information about a foreign individual(s) that own directly 20% or more, or own 50% or more of the company’s voting stock on Schedule G, Form 1120.Liability: LimitedTaxation of Gains on Sale: No preferential tax treatment for long-term capital gains. On the Federal level, a gain realized from the sale of New York City real estate will be taxed at graduated corporate income tax rates (up to 35%). Additionally, there will be New York State corporate franchise tax and New York City corporate tax at a combined income tax rate of more than 17%. After claiming state and local tax deductions on the federal tax return, the combined effective tax rate could approach 46%.Repatriation of Funds: U.S. Withholding Tax: Distribution of the company’s after-tax gains from the sale of the property to a foreign company’s shareholder will be subject to automatic withholding tax of 30%, although a reduced rate of exemption may apply if stipulated in the applicable tax treaty.Taxation of Rental Income: Rental income will be taxed in the same way as the gains that the company realizes from the sale of the property – subject to withholding upon distribution.Estate Taxes: Nonresident’s shares in a domestic corporation are subject to estate taxation. Applicable estate tax exemption is $60,0000.
FOREIGN CORPORATION OWNS NEW YORK REAL ESTATE THROUGH DOMESTIC CORPORATION – U.S. BLOCKER STRUCTURE
U.S. Blocker structure allows to eliminate estate taxes and FIRPTA withholding requirements with proper planning and execution. This structure affords the owner both asset protection and privacy.
If the foreign investor establishes a foreign corporation that in turn owns 100% of U.S. corporation that owns New York real estate, the foreign investor will be able to avoid any U.S. estate tax completely since nothing in the U.S. is transferred in the event of the death.
FIRPTA withholding requirements can also be avoided when the real estate is sold because the seller of real estate is a domestic entity.
The U.S. corporation will, however, be required to pay high corporate capital gains tax rate when the property is sold, and repatriation of profits to the foreign shareholder will be subject to flat tax of 30% (unless reduced by an applicable tax treaty).
Privacy: Limited. Name of the company’s owner does not appear in public records (ACRIS).Reporting: In the end of a given tax year, a company files Federal and New York State corporate income tax returns. The Federal income tax return is filed on Form 1120. The company would have to report information about a foreign shareholder on Form 5472 (information return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in U.S. Business).Liability: LimitedTaxation of Gains on Sale: No preferential tax treatment for long-term capital gains for a corporation. On the Federal level, a gain realized from the sale of New York City real estate will be taxed at graduated corporate income tax rates (up to 35%). Additionally, there will be New York state corporate franchise tax and New York City corporate tax (8.85%) at a combined income tax rate of more than 17%. After claiming state and local tax deductions on the federal tax return, the combined effective tax rate could approach 46%. No U.S. branch profit tax of 30% since real estate and income generated therefrom reside in a U.S. corporation.Withholding Tax Due on Sale: No FIRPTA or New York State withholding tax because real estate is owned by a U.S. corporation. However, withholding tax upon repatriation of funds applies as described below.Repatriation of Funds: Distribution of the company’s after-tax gains from the sale of the property to a foreign company’s shareholder will be subject to automatic withholding tax of 30%, although a reduced rate of exemption may apply if stipulated in the applicable tax treaty.Taxation of Rental Income: Rental income will be taxed in the same way as the gains earned from the sale – subject to 30% withholding upon distribution.Estate Taxes: None
OWNERSHIP OF NEW YORK CITY REAL ESTATE THROUGH LEVERAGED CORPORATE STRUCTURE
Leveraged ownership structures are complex and expensive, and are recommended for large investments in U.S. real estate.
Generally, a foreign person can benefit from self-financing their investments in the U.S. real estate.
When a foreign person loans part of the investment to acquire New York City real estate, such loan can generate tax deductions to the U.S. entity that owns real estate. Because such U.S. entity can deduct the interest, this lowers the effective U.S. tax rate.
If the transaction is properly structured, the debt can also produce an interest income to the client that would be free from U.S. income taxes or withholdings.
Any leveraged ownership structures require extensive planning and involves several complex tax provisions dealing with portfolio interest exemption and income stripping rules.
“PORTFOLIO INTEREST” DEBT STRUCTURES
The U.S. imposes a 30% withholding tax on Fixed, Determinable, Annual, Periodical (FDAP) income that includes interest income. The U.S. payor of FDAP income is required to make the withholding from the payment to a nonresident and to remit the withheld amount to the IRS.
However, certain interest that qualifies as “portfolio interest” is exempt from U.S. taxation and tax withholding.
For example, instead of investing directly in New York real estate, a foreign client can integrate a loan into the investment structure that could qualify for “portfolio interest” exception, making any payments on such loan, including interest and principal, tax free if structured properly.
In contrast, dividends paid to non-U.S. residents are taxable in the U.S.
However, the U.S. places tight limitations on the availability of the “portfolio interest” exemption, including:
- Interest received by a “10% shareholder”
- Interest received by a controlled foreign corporation (CFC) from a related person
- Interest received by a bank on an extension of credit made pursuant to a loan agreement entered into in the ordinary course of its trade or business
In addition, “income-stripping” rules might apply to the “portfolio interest” structures, disallowing a deduction of disqualified interest paid or accrued by U.S.-based entity.
As such, a proper structuring of “portfolio interest” transaction requires careful planning and execution.
NEW YORK REAL ESTATE INVESTMENT STRUCTURES THROUGH APPLICABLE BILATERAL TAX TREATIES
The U.S. maintains bilateral tax treaties with 68 countries.
Under these treaties, residents of foreign countries are taxed at a reduced rate, or are exempt from U.S. taxes on certain items of income they receive from sources, including real estate, within the U.S. The impact of tax treaties can be quite significant for the client’s bottom line, substantially reducing U.S. income and withholding taxes.
For example, some treaties completely eliminate U.S. withholding tax on repatriation of profits (payments of U.S.-source dividends). Others reduce the applicable withholding tax rate to 15%, 10% or 5%.
In addition to repatriation of profits, a foreign person might benefit from leveraging its investment in the U.S. real estate under applicable bilateral treaty.
For example, the U.S. bilateral tax treaties with United Kingdom, Canada, France, Norway, Germany, Russia, Ukraine and several other countries eliminate U.S. withholding tax on payment of interest to a foreign person, regardless of relationship between the borrower and the lender.
Under the U.S. tax treaty with China, the U.S. tax on interest income earned by Chinese individuals and companies in the U.S. may not exceed 10% subject to certain exceptions.
A handful of treaties even eliminate U.S. withholding tax on contingent interest.
With proper structuring, the tax savings could be very significant allowing effective tax rate reductions of up to 70-80%, making a client’s investment in U.S. real estate much more attractive. In some cases, income taxes can be eliminated completely.
Qualifying for these special Bilateral Tax Treaty-based exemptions requires careful planning.
Contact NYC Real Estate Attorneys Specializing on Structuring Foreign Investment in U.S. Real Estate
Before making a substantial investment in New York City real estate, foreign investors should fully consider the U.S. tax consequences of their investment, including those that arise when the property is sold and proceeds are repatriated. We have substantial experience advising individuals, families and investment funds in connection with inbound U.S. transactions, including investments in New York City real estate.
Resources for Foreign Sellers and Buyers of NYC Real Estate:
- Withholding of Tax on Dispositions of US Real Property
- Tax / Fee Calculator for Foreign Sellers and Buyers of New York City Real Estate
- New York Source Income of Nonresident Individuals: Real Estate
- New York State Income (Withholding Tax) Tax for Foreign Sellers of New York City Real Estate
- Structuring Investment in U.S. Real Estate by Foreign Persons
- FinCen Rules Requiring Identification for High-End Cash Buyers of Manhattan Real Estate
- Foreign Investors Receiving Rental Income from US Real Estate
- ITIN Guidance for Foreign Property Buyers/Seller
- New York City Property Deed Records: ACRIS
- Foreign Investment in Real Property Tax Act
- How Foreign Investors Can Reduce or Eliminate FIRPTA Withholding
- Rules Governing FIRPTA Withholding
- Format of Applications for FIRTPA Withholding Certificate
- Association of Foreign Investors in U.S. Real Estate
- Tax Disclaimer: The information contained herein is general in nature and based on authorities that are subject to change. We do not guarantee neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. We assume no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations.
- Circular 230 Disclosure: This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.